Markets at a Crossroads

Key Takeaways

We believe that capital markets are at an inflection point that could lead to a move in either direction.

The recent strength in equities amid continued economic uncertainty may reflect some investor complacency. We recently lowered our guidance on select U.S. equity classes to capitalize upon recent equity strength while also aiming to reduce the overall portfolio risk profile.

What it May Mean for Investors

Capital markets appear to be at a crossroads. We believe investors can position their portfolios to address economic uncertainty by increasing their allocations to Cash Alternatives in line with our tactical allocations, which are currently above our strategic allocations to this asset class.

Investors also can consider aligning their equity exposure with our current tactical guidance on U.S. Large Cap and Mid Cap Equities (neutral or in line with strategic targets) and with our unfavorable guidance on U.S. Small Cap Equities (underweight versus the strategic target).

We believe that capital markets may be at a crossroads, given the softness in recent economic data. So far, the global equity rally has dismissed recession fears, but the economic and earnings fundamentals remain uncertain. Such is the nature of retracements after indiscriminate sell-offs like the one we saw late last year. Put another way, we see the global capital markets today at a potential inflection point—a level from which prices could pivot higher or lower. The pivot direction ultimately should depend upon how the economic uncertainties resolve in the coming weeks and months.

To us, this disconnect between fundamentals and equity markets may represent some complacency, and we continue to make guidance changes to reflect this fact (as we also seek to capitalize upon the recent market rally). As a reminder, in January, we reduced our U.S. Small Cap Equities guidance and also reduced their allocations. More recently, with the U.S. equity market continuing to grind higher, we took the opportunity to reduce our guidance on U.S. Large Cap Equities and Mid Cap Equities. We also moved capital out of U.S. Large Cap Equities and into Cash Alternatives.

As in January, our focus remains cautious, but it does not imply a negative equity outlook. If the economic data continue to weaken, we may further (and selectively) reduce portfolio exposure to economic risk; alternatively, if the data strengthen, we could favor taking more risk in equities.

We reiterate a critical point that we touched on in the 2019 Outlook report’s main theme, “the end of easy.” The asset-price trends that advanced easily and without much interruption until 2018 were unusually long, but they may now be over. Looking ahead, we expect muted equity market gains, as political events, and the possibility of rising interest rates, and concerns about the aging economic expansion could disrupt sentiment periodically. Above all, risk and reward are now changing more quickly, and investors may need to adjust portfolio positioning more often.

Given the current level of uncertainty against the backdrop of high equity market valuations, we now view Cash Alternatives as an attractive asset class. We have upgraded Cash Alternatives from neutral to favorable. On a return basis, Cash Alternatives have usually provided a similar yield to U.S. Short Term Taxable Fixed Income (a most favorable asset class), and a yield that is above the comparable total return we foresee for U.S. Long Term Taxable Fixed Income.1

Above all, in an environment characterized by uncertainty, volatility, and higher valuations, the reallocation of funds from U.S. Large Cap Equities into Cash Alternatives (now favorably rated) gives us flexibility to potentially reallocate assets back into equity, fixed income, and real asset markets when opportunities arise.

Equities

We have adjusted our equity guidance on the Emerging Europe, Middle East, and Africa (EMEA) region from most favorable to favorable. While our view remains most favorable on emerging market (EM) equities overall, we believe that Emerging Asia and Latin America offer better near-term prospects than the EMEA region today.

Fundamentals remain mostly sound across the EMEA region, and we have seen some recent positive economic surprises across the region. There also have been meaningful year-to-date returns. Our currently favorable view stems from the fact that we see reasons for slightly more caution in EMEA than we see in other regions. Economic growth has slowed somewhat, particularly in emerging European countries, such as Russia and Turkey. Earnings expectations among the region’s banks and exporters have deteriorated recently, especially for countries with exposure to developed Europe (specifically, Germany, Italy, and the U.K.). Recent price gains also leave valuations somewhat less attractive than they were at year-end 2018. While our outlook remains positive; it compares less favorably to our expectations for other EM regions.

As growth continues to slow in developed economies, we expect more resiliency and return potential from EM equities. We decreased our eurozone gross domestic product growth forecast on March 7. This decline, along with slowing U.S. economic growth, reflects a further slowdown in the developed market economic cycle. As such, we believe that the best equity opportunities are in EMs today—as we believe they have brighter growth prospects over the three-to-five year horizon.

Key takeaways

We have a favorable view on the EMEA region and are most favorable on EM equities as a whole. The move from most favorable to favorable is on a relative basis (when compared to most favorable opportunities in Emerging Asia and Latin America).

Fixed Income

Eurozone inflation expectations and negative rates

Ten-year German bund yields declined in late 2018; that decrease continued in the first quarter—driven mainly by data disappointments, suggesting a sharp slowdown in activity. For example, the Markit Manufacturing Purchasing Managers’ Index (PMI) had fallen below 50 by February—a rapid decline from the third-quarter level of approximately 55. The European Central Bank’s (ECB) dovish turn at its March meeting validated market concerns as the ECB cut its 2019 inflation forecast from 1.6% to 1.2%.

The chart shows that market expectations mirrored private-sector and ECB economists’ inflation outlook downgrade.2 A key indicator has fallen below 1.50%, edging into a range last seen in 2016, during a period that coincided with an ECB policy rate cut to -0.40%, along with 10-year German bund yields trading as low as -0.20%.

We cannot rule out a new German bund move into negative yield territory—since the economic outlook is uncertain; the ECB is still reinvesting cash flows into German bunds; and the supply/demand balance remains tight. Further, risk events such as Brexit and European parliamentary elections in May raise the possibility of renewed flight-to-quality flows into bunds. But a “bottoming out” of the eurozone economic slowdown could quickly move sovereign yields in the opposite direction, and negligible coupon income would mean virtually no cushion against capital losses in that event. We remain unfavorable on developed market (DM) fixed income (ex-U.S.) for now.

Key takeaways

Weakening growth and falling inflation expectations have driven 10-year bund yields close to 0%. A fall into negative territory is possible, given the supply/demand balance and risk events, including Brexit and European parliamentary elections.

Even if further yield declines generate modest capital gains, DM bond returns are vulnerable, as negligible coupon income offers no cushion against capital and currency losses. We retain our unfavorable DM debt view for now.

Real Assets

Austin Pickle, CFA, Investment Strategy Analyst

“The U.S. trade deficit is nearly gone.”

“What I spent, is gone; what I kept, I lost; but what I gave away will be mine forever.”
--Ethel Percy Andrus

The title above is missing the word “petroleum.” The U.S. petroleum trade deficit is nearly gone. The total U.S. goods trade balance is still at record deficits. Yes, it is a “clickbait” title, but you are here now—so you might as well read on.

The improvement in the petroleum trade balance is a truly remarkable feat. As recently as 2011, petroleum accounted for more than 50% of the total U.S. goods deficit. Today, it represents less than 2% (orange line in the chart below). The shale effect (i.e., historic levels of U.S. petroleum production; removal of export restrictions; and a build-out of petroleum infrastructure and export capacity) has driven the improvement. And this trend is expected to continue—the Energy Information Administration forecasts that the U.S. will be a net petroleum exporter by 2021 and a net energy exporter (petroleum, natural gas, etc.) next year for the first time since the 1950s. With mounting concern over the historic total trade deficit, energy is one of the few bright spots.

If the administration wants to foster this strength, we would caution to not push hard for lower oil prices. Oil prices that are too low could cause production to slow, infrastructure spending to collapse, and exports to stagnate. But “too high,” and the consumer and economy generally would be negatively impacted. Given current breakeven levels, a range of $55-$70 seems to be the sweet spot for West Texas Intermediate crude that should encourage production, investment, and exports without crimping economic growth.

Alternative Investments

Headline corporate default rates continue to hover near historical lows, likely aided by the Federal Reserve’s dovish pivot and by a rebound in high-yield (HY) debt issuance. Further, the year-to-date volume of fallen angels stands just below 9% of rising-star volume.3 But beneath the surface, the picture is increasingly murky. Credit downgrades from rating agencies outnumbered upgrades by a ratio of 2:1 in February. This coincided with a slowdown in adjusted and unadjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) for HY debt issuers that was reflected in fourth-quarter earnings. Moreover, distress ratios across several sectors are at least as high (or higher) than at this time last year (see chart).

Our views on the “distressed” opportunity set for hedge funds and private capital do not rely upon a specific default-rate projection. In fact, we believe that much of these strategies’ opportunities come at this point in the cycle, when defaults are low, yet companies are beginning to show signs of stress. Hedge funds can capitalize upon a growing list of catalysts, such as downgrades, refinancings, bankruptcies, and defaults. Private capital strategies can lend to challenged companies at very attractive rates, or opportunistically take control, restructure debt, and exit holdings at an attractive premium.

Although low default rates suggest that credit-market conditions may be benign, the reality for hedge fund and private capital strategies is that there is no shortage of opportunities to lend to (and trade) companies facing fundamental challenges.

Key Takeaways

Default rates remain near historically low levels, yet we continue to see signs of stress under the surface.

Much of the hedge fund and private capital opportunity comes when defaults are low and there are catalysts for trading and lending-based strategies.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

1 Cash alternatives can include money market funds, short-term CDs, short duration bonds; deposit accounts, Treasury bills; savings accounts. Please see the end of this report for important risk considerations associated with this asset class.

2 As measured by the five-year, five-year forward inflation swap rate. An inflation swap is a derivative used to transfer inflation risk from one party to another through an exchange of cash flows. The Euro five-year, five-year forward inflation swap rate is a common measure used by central banks and market participants to gauge the market’s future inflation expectations.

3 Bank of America, High Yield Credit Chartbook, March 2019. Fallen angels are companies that experience ratings downgrades that move their debt from investment grade to high yield.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Cash Alternatives: Each type of cash alternatives, such as bank certificates of deposits, Treasury bills, ultra-short bond mutual funds, variable rate demand notes and money market funds, has advantages and disadvantages. They typically offer lower rates of return than longer-term equity or fixed-income securities and may not keep pace with inflation over extended periods of time. While government savings bonds, U.S. Treasury bills, and other U.S. government securities are backed by the full faith and credit of the federal government if held to maturity, other cash alternatives carry higher default risk.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

Distressed Debt: Private debt strategies seek to actively improve the capital structure of a company often through debt restructuring and deleveraging measures. In private debt investments, an investor acts as a lender to private companies and loans have specific contractual interest rate terms and repayment schedules. Such investments are subject to potential default, limited liquidity, the creditworthiness of the private company, and the infrequent availability of independent credit ratings for them. Because of their distressed situation, private debt funds may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks. These funds often demand long holding periods to allow for the end of the debt's term or an exit strategy via the secondary market which is not guaranteed to exist or develop.

Definitions

The MSCI EAFE (DM) and Emerging Markets (EM) Indices are equity indices which capture large and mid cap representation across 21 developed market (DM) countries and 23 emerging market (EM) countries around the world.

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The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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